A Review of FINRA’s Corporate Finance Rule

by Laura Anthony, Esq. on October 06, 2021 in Uncategorized

As the strongest U.S. IPO market in decades continues unabated, it seems a good time to talk about underwriter’s compensation.  FINRA Rule 5110 (Corporate Financing Rule – Underwriting Terms and Arrangements) governs the compensation that may be received by an underwriter in connection with a public offering.

Rule 5110 – The “Corporate Financing Rule”

Rule 5110 regulates underwriting compensation and prohibits unfair arrangements in connection with the public offerings of securities.  The Rule prohibits member firms from participating in a public offering of securities if the underwriting terms and conditions, including compensation, are unfair as defined by FINRA.  The Rule requires FINRA members to make filings with FINRA disclosing information about offerings they participate in, including the amount of all compensation to be received by the firm or its principals, and affiliations and relationships that could result in the existence of a conflict of interest.  As more fully described herein, underwriter’s compensation is subject to lock-up provisions.

Filing Requirements

Rule 5110 requires a member that participates in a public offering to file documents and information with FINRA about the underwriting terms and arrangements.  The 5110 filing must be made within three (3) business days after any documents (generally an S-1 or Form 1-A but the Rule is broad enough to cover any public offering filing) are filed with or submitted to the SEC, including confidential filings.  I note that the Rule used to require a filing to be made within one business day, but the time was extended by amendment in March 2020.  The material submitted is confidential and not available to the general public.

Where an offering is syndicated amongst multiple firms, only the managing underwriter, or where multiple managers, only one syndicate member firm, is required to make the filing.  The filing firm must keep the other syndicate members apprised of FINRA comments which are generally in the form of a letter stating that one or more term is unfair or unreasonable.  The underwriting may not continue until FINRA has confirmed that it has no objection to the underwriting terms and arrangements.

A 5110 filing is accomplished through the submittal of certain documents and information through the FINRA portal and in particular:

  • the registration statement, offering circular, offering memorandum, notification of filing, notice of intention, application for conversion, and any other document used to offer securities to the public (the firm may provide the document number on the EDGAR database in lieu of actual documents);
  • all documents relevant to the underwriting terms and arrangements, including any proposed underwriting agreement, agreement among underwriters, selected dealer’s agreement, agency agreement, purchase agreement, letter of intent, engagement letter (to the extent it impact’s underwriter’s compensation), consulting agreement, partnership agreement, underwriter’s warrant agreement, or escrow agreement, provided that industry-standard master forms of agreement need not be filed unless otherwise specifically requested by FINRA;
  • any amendments to the previously filed documents to the extent they impact underwriter’s compensation;
  • final registration or equivalent document declared effective by the SEC and the notice of effectiveness; and
  • all requests for withdrawal of any documents filed with the SEC.

In addition to the document filing requirement, the 5110 filing must include:

  • an estimate of the maximum offering price;
  • an estimate of the maximum value for each item of underwriting compensation;
  • a representation as to whether any officer, director, or 10%+ shareholder of the issuer is an associated person or affiliate of the member firm (prior to March 2020, the ownership threshold was 5%);
  • a description of any securities acquired or beneficially owned by the member firm and a copy of any non-convertible or non-exchangeable debt instrument or derivate security obtained in connection with the public offering must be filed with FINRA;
  • any applicable representations when claiming any compensation can be excluded from underwriting compensation under the Rule;
  • the SEC registration statement number for any shelf offering on Form S-3, F-3, F-10 or similar (to facilitate quick access to capital, FINRA will review this filing on a post-takedown basis); and
  • an explanation and documents related to any modification of any documents or information previously submitted in accordance with Rule 5110.

A member firm must also inform FINRA if an offering is not completed and underwriting compensation is received, such as expense reimbursements. Similarly, a member must inform FINRA when an agreement’s termination provision is triggered.  If there is a revised offering is within the review period (as discussed below) of the terminated offering, FINRA will aggregate compensation received in the prior terminated offering.

Issuer Disclosure

Although Item 508 of Regulation S-K requires an issuer to disclose underwriter’s compensation as part of its plan of distribution, and Item 501 requires an issuer to disclose underwriter discounts on the forepart of a registration statement and outside front cover page of a prospectus, Rule 5110 extends these obligations to the underwriter itself.  In particular, Rule 5110 imposes a requirement that each item of underwriter compensation received or to be received be disclosed in the section on distribution arrangements in the prospectus or similar document.  The Rule 5110 underwriter compensation lock-up provisions must also be disclosed in this section.  Rule 5110 also requires that any underwriting commission or discount to the public offering price be disclosed on the cover page of the prospectus or similar document and that such disclosure include a footnote cross-referencing the distribution section for a complete explanation of underwriter’s compensation.

Filing Requirement Exemptions

Rule 5110 includes two categories of exempt public offerings—offerings that are exempt from filing but remain subject to the substantive provisions of Rule 5110 and offerings that are exempt from both the filing requirements and substantive provisions of Rule 5110. The amendment reorganizes, expands and clarifies the scope of these exemptions.

Underwriters need not file under rule 5110 (unless there is a conflict of interest such as that a member firm is a control person of the issuer) for offerings: (i) by a bank, corporation or foreign government that has outstanding investment grade unsecured non-convertible debt or preferred securities with a term of at least four years except if the offering is an initial public offering of equity; (ii) investment grade non-convertible debt or preferred securities; (iii) offerings registered with the SEC on Forms S-3, F-3 or F-10 for experienced issuers (i.e., an issuer with a 36-month reporting history and at least $150 million aggregate market value of voting stock held by nonaffiliates or, alternatively, the aggregate market value of voting stock held by non-affiliates is at least $100 million and the issuer has an annual trading volume of three million shares or more in the stock); (iv) investment grade rated financing instrument-backed securities; (v) exchange offers where the securities to be issued are listed on a national exchange or the company listing securities qualifies for (iii) above; (vi) public offerings by a church or other charitable institution; and (vii) offerings of securities issued by a pooled investment vehicle not registered under the Investment Company Act and which already has a class of redeemable securities listed for trading on a national securities exchange.

What is Considered Underwriter’s Compensation?

Underwriter’s compensation is broadly defined as “any payment, right, interest, or benefit received or to be received by a participating member from any source for underwriting, allocation, distribution, advisory and other investment banking services in connection with a public offering. In addition, underwriting compensation shall include finder’s fees, underwriter’s counsel fees, and securities.”  Any payment, right, interest or benefit that meets the definition of “underwriting compensation” received by participating members during the applicable review period will be presumed to be underwriting compensation.

FINRA considers any compensation received or to be received within a “review period.” “Review period” is defined as: (i) for a firm commitment offering, the 180-day period preceding the required filing date through the 60-day period following the effective date of the offering; (ii) for a best efforts offering, the 180-day period preceding the required filing date through the 60-day period following the final closing of the offering; and (iii) for a firm commitment or best efforts takedown or any other continuous offering made pursuant to Securities Act Rule 415, the 180-day period preceding the required filing date of the takedown or continuous offering through the 60-day period following the final closing of the takedown or continuous offering.

Non-convertible or non-exchangeable debt securities and derivative instruments acquired in a transaction unrelated to a public offering is not considered underwriting compensation.  Where such instruments are considered compensation, Rule 5110 provides mathematical formulas for valuing these convertible and non-convertible securities for purposes of determination of total underwriter’s compensation.  However, a member firm may reduce the value of any securities received as underwriting compensation by voluntarily agreeing to a lock-up of such securities for successive 180-day periods.  Each additional 180-day period will reduce the proposed maximum value attributable to such securities by 10%.

Rule 5110 also provides a non-exhaustive list of examples of payments or benefits that are not considered underwriters compensation (and thus not subject to the required lock-up provisions).  Payments or benefits are generally not underwriting compensation when received by members for providing services unrelated to the public offering and when the payments or benefits are consistent with those received by other similarly situated persons and which are customary and appropriate for the services provided.   Securities acquired in some transactions identified in the examples (e.g., securities acquired in a dividend paid during the review period or as a result of a conversion of securities originally acquired before the review period) are the result of bona fide financing or investing activities that are unrelated to the public offering.

Similarly, investments by a member firm, prior the filing of a registration statement or similar document, on the same terms and conditions as other investors, will generally not be considered underwriters compensation.  Rule 5110 has a series of Venture Capital Exceptions in that regard.  FINRA also allows for funding of a company when a public offering has been delayed.  Whereas the Venture Capital Exceptions are more prescriptive, determining whether a particular financing or investment is underwriter’s compensation when a public offering is delayed following the filing of a registration statement, is principles based.  Among other factors, FINRA will consider (i) the length of time between the date of filing a registration statement or similar document and the relevant funding; (ii) the length of time between the date of a funding and the anticipated public offering; and (iii) the nature of the funding provided.

On the other hand, examples of securities acquisitions that are intended to provide underwriting compensation to a participating member related to the public offering under review include acquisitions where the terms of the securities were altered to provide additional compensation to the participating member during the review period or where the securities were acquired in a transaction that was intended primarily to compensate the participating member related to the public offering, such as a transaction where only the participating member is offered the opportunity to invest.

Rule 5110 also restricts certain types of non-cash compensation.  A FINRA member or associated person may only accept non-cash compensation as follows: (i) gifts valued under $100 per year and only if the gift is not preconditioned on achieving a sales target; (ii) an occasional meal, a ticket to a sporting event or the theater, or comparable entertainment which is neither so frequent nor so extensive as to raise any question of propriety and is not preconditioned on achievement of a sales target; (iii) payment or reimbursement by offerors in connection with meetings held by an offeror or by a member for the purpose of training or education of associated persons of a member and limited to certain circumstances; (iv) non-cash compensation arrangements between a member and its associated persons or a company that controls a member company and the member’s associated persons; or (v) contributions by a non-member company or other member to a non-cash compensation arrangement between a member and its associated persons under certain circumstances.

Lock-Up Restrictions

Subject to some exceptions, Rule 5110 requires a 180-day lock-up restriction on any securities that constitute underwriters compensation.  During the lock-up period the securities may not be sold or transferred, pledged as collateral or made subject to any derivative contract (put or call option, etc.).  The lock-up period takes effect on the date of commencement of sales (rather than the date of effectiveness of the prospectus).

Exceptions to the lock-up restrictions include: (i) securities acquired from an issuer that is S-3F-3 or F-10 eligible; (ii) securities acquired in a transaction meeting one of the Venture Capital exceptions; (iii) securities that are “actively traded” (i.e., have an average daily trading volume value of at least $1 million and are issued by an issuer whose common equity securities have a public float value of at least $150 million—provided, however, that such securities are not issued by the distribution participant or an affiliate of the distribution participant); (iii) securities that were received as underwriting compensation and are registered and sold as part of a firm commitment offering; and (iv) the security is required to be transferred by operation of law or by reason of a reorganization of the issuer; (v) the aggregate amount of securities of the issuer beneficially owned by a participating member does not exceed 1% of the securities being offered; (vi) non-convertible or non-exchangeable debt securities acquired in a transaction related to the public offering; (vii) if the security is beneficially owned on a pro-rata basis by all equity owners of an investment fund, provided that no participating member manages or otherwise directs investments by the fund, and participating members in the aggregate do not own more than 10% of the equity in the fund; and (viii) derivative instruments acquired in connection with a hedging transaction related to the public offering and at a fair price.

The lock-up restrictions do not prohibit: (i) the transfer of any security to any member participating in the offering and its officers or partners, its registered persons or affiliates, if all transferred securities remain subject to the lock-up restriction for the remainder of the 180-day lock-up period; (ii) the exercise or conversion of any security, if all securities received remain subject to the lock-up restriction for the remainder of the 180-day lock-up period; or (iii) the transfer or sale of the security back to the issuer in a transaction exempt from registration with the SEC.

Unreasonable Terms and Arrangements

Rule 5110 sets forth certain terms and arrangements which are considered unreasonable.  These include:

  • receipt of any underwriting compensation, including in the form of securities, for which a value cannot be determined;
  • any accountable expense allowance that includes payment for general overhead, salaries, supplies, or similar expenses incurred in the normal conduct of business;
  • any non-accountable expense allowance in excess of 3% of offering proceeds;
  • any underwriting compensation paid prior to the commencement of sales of the public offering, except an advance against accountable expenses expected to be incurred and that will be reimbursed if not incurred or advisory or consulting fees for services provided in connection with the offering;
  • any underwriting compensation in connection with a public offering that is not completed according to the terms of an agreement entered into by an issuer and a participating member, except expense reimbursement or a termination fee or right of first refusal provided there is a written agreement allowing the issuer to terminate for cause and that in the event of such termination for cause, no fee is due;
  • a termination fee and right of first refusal must be reasonable in relation to the underwriting services and must be customary for those type of services;
  • a termination fee cannot be imposed for a transaction that is consummated later than two years form the date the engagement is terminated with the issuer;
  • a right of first refusal cannot be longer than three years and cannot have more than one opportunity to waive or terminate the right of first refusal in consideration of any payment or fee;
  • any payment or fee to waive or terminate a right of first refusal to participate in a future public offering, private placement or other financing that is not paid in cash;
  • the receipt of underwriting compensation consisting of any option, warrant or convertible security that: (a) is exercisable or convertible more than five years from the commencement of sales of the public offering; (b) has more than one demand registration right at the issuer’s expense; (c) has a demand registration right with a duration of more than five years from the commencement of sales of the public offering; (d) has a piggyback registration right with a duration of more than seven years from the commencement of sales of the public offering; (e) has anti-dilution terms that allow the participating members to receive more shares or to exercise at a lower price than originally agreed upon at the time of the public offering, when the public shareholders have not been proportionally affected by a stock split, stock dividend, or other similar event; or (f) has anti-dilution terms that allow the participating members to receive or accrue cash dividends prior to the exercise or conversion of the security;
  • any overallotment option providing for the overallotment of more than 15% of the amount of securities being offered, computed excluding any securities offered pursuant to the overallotment option;
  • the receipt by a participating member of any compensation in connection with the exercise or conversion of any warrant, option, or convertible security offered in the public offering if: (a) the market price of the security into which the warrant, option, or convertible security is exercisable or convertible is lower than the exercise or conversion price; (b) the security is held in a discretionary account at the time of exercise unless specific approval is received from the customer; (c) the compensation arrangements are not disclosed in the offering documents provided to security holders at the time of exercise or conversion; or (d) the exercise or conversion is not solicited by the participating members; and
  • for a member to participate in a public offering of securities where the issuer hires persons primarily for the purpose of solicitation, marketing, distribution or sales of the offering, unless such persons that are required to be registered, are registered.

Independent Financial Advisor Exception

Rule 5110 provides that an “independent financial adviser” that provides advisory or consulting services to the issuer would not meet the definition of “participation in a public offering” would therefore not be subject to the compensation limitations of Rule 5110, lock-up period and information filing requirements. The Rule defines an independent financial adviser as “a member that provides advisory or consulting services to the issuer and is neither engaged in, nor affiliated with any entity that is engaged in, the solicitation or distribution of the offering.”  The Rule allows issuers to engage member firms to provide advice and consultation regarding financing options, the advantages and disadvantages of these options, the terms and conditions of an underwriting proposed by another member firm (assuming the advisory and underwriter firm are independent of each other), and all matters of corporate finance without automatically being deemed to be engaged in a public offering should one ensue.  If the firm also engages in solicitation or distribution activities in addition to providing advisory or consulting services, the exclusion of the advisory-related compensation is not be available and all of the compensation received by that firm in connection with the offering is subject to the compensation limitations and disclosure requirements.

Definition of Public Offering

A “public offering” is broadly defined to include any primary or secondary offering of securities made in whole or in part in the US pursuant to a registration statement, offering circular (i.e., Form 1-A in a Regulation A offering) or similar offering document including exchange offers, rights offerings, and offerings of securities made pursuant to a merger or acquisition except for:

  • securities exempt from registration under the Securities Act by Sections 4(a)(1) (i.e., transactions by a person other than an issuer, underwriter or dealer); 4(a)(2) (transactions not involving a public offering); or 4(a)(5) (limited accredited investor exemption);
  • securities exempt under Rule 504 as long as the securities will be restricted, and Rule 506 of Regulation D;
  • securities exempt under Rule 144A or Regulation S; or
  • securities exempt under Section 3(a)(12) of the Securities Act (bank holding company acquisitions).